Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Thursday, February 02, 2012

MSRB Urges SEC to Include All Municipal Securities, as Defined in 1934 Act, Within Volcker Rule Governmental Obligations Exemption

The Municipal Securities Rulemaking Board urged the federal financial regulators implementing the Dodd-Frank Volcker Rule provisions to broaden the governmental obligations exemption from the proposed regulation’s restriction on proprietary trading to include all municipal securities as defined in the Securities Exchange Act. In a letter to the SEC and banking agencies, the MSRB said the broad exemption is needed to avoid a bifurcation of the municipal securities market that will, in the Board’s view, achieve no meaningful additional benefit to the safety and soundness of the banking system.

The MSRB said that it is essential that the governmental obligations exemption be expanded, because the exemptions from the proprietary trading prohibition for underwriting activities, trading on behalf of customers, and market making activities are structured in such a way that they are not useful in the municipal securities market. Unless changed, the proposed regulations will serve as an impediment to a free and open market in municipal securities to the detriment of investors and issuers of municipal securities.

The letter points out that the narrowness of the government obligations exemption is not mandated by Dodd-Frank and that banking and securities law definitions of political subdivision that pre-date Dodd-Frank, and that gave expansive meaning to the term political subdivision to effectively parallel the definition of municipal securities under the Exchange Act, might well have been considered by Congress in drafting this provision of Dodd-Frank.

The MSRB urged the regulators to use the Exchange Act definition of municipal security, which the Board said was the most comprehensive definition. The covered banking entities that underwrite and trade in the municipal securities market must all apply the Exchange Act definition as a regular part of their activities, noted the MSRB, adding that the use of he Exchange Act definition will promote consistency of regulation of brokerage firms and covered banking entities, which promotes fair and efficient markets.

Given the extremely divergent ways in which the 50 states organize and empower theirsubdivisions, municipalities, and authorities, noted the MSRB, the distinction drawn by the Volcker proposed regulations between those municipal securities that would be treated as governmental obligations and those that would not ultimately results in an adherence to form over function. In the view of the MSRB, there is no principled basis for maintaining such a distinction that is consistent with the purposes of the overall Volcker regulations or of the governmental obligations exemption.

Two issues of securities with identical terms and provisions, and with identical risk profiles, and which otherwise would exhibit the identical trading behavior, would be treated in completely different ways under the Volcker Proposal because the too narrowly tailored provisions of the governmental obligations exemption would treat one issue as a governmental obligation and the other one as a covered financial position. Given that the various existing federal statutes that use different terminology to describe municipal securities nonetheless have consistently been interpreted and applied to cover effectively the same universe of securities as set forth in the definition of municipal securities under the Exchange Act, reasoned the MSRB, there is no reason to believe that Congress intended to carve out a subset of such securities in a manner that did not promote any discernible or effective public policy.

There are some substantial differences between the corporate debt market and the municipal securities market that limit the usefulness of the underwriting activities exemption in the municipal securities market. For example, many state laws require competitive underwritings for certain types of issuers or bond types, rather than the negotiated underwritings that are the norm in the corporate debt markets. In addition, while the corporate debt market is characterized by a relatively small number of issuers and debt issues of significant size, noted the MSRB, the municipal securities market is characterized by a much larger number of issuers and much smaller issue sizes.

The trading on behalf of customers exemption would effectively require covered banking entities either to act in a fiduciary capacity for a customer or as a riskless principal. Those limits would make the exemption largely ineffectual in the municipal securities market. Most municipal securities transactions are executed by broker-dealers in a principal capacity, which does not give rise to a fiduciary duty under current law. But note that the Dodd-Frank Act directed the SEC to conduct a study on creating a single fiduciary standard for dealer and investment advisor transactions for or on behalf of retail customers and empowered the SEC to engage in rulemaking to create such a standard. If the SEC were to create such a single fiduciary standard, reasoned the MSRB, the Volcker Rule might then view such retail sales as meeting the exception for trading on behalf of a customer.

The general prohibition against proprietary trading does not apply to market-making activities. But the definition of market maker is unlikely to be of much use in the municipal securities market since dealers in municipal securities do not regularly or typically post bid-ask prices for a significant number of municipal securities.